With banking stocks benefiting the most in the latest market rally, experts seem to be getting optimistic on the fate of the sector. Both Morgan Stanley and Nomura recently took an optimistic stance on the sector, citing a receding bad loan cycle and changes in market expectations of the interest rate cycle.

Such expectations seem to be playing out already with the sectoral index on the BSE, the Bankex, rallying as much as 19% against an 8% increase by the 30-share Sensex. Although private sector banks like Axis bank, IndusInd bank, Yes Bank and ICICI Bank have led the Bankex, with each of these stocks rallying more than 20% over the period, the entire banking pack has outdone the market given that even smaller PSU banks like Federal bank, Union bank and Canara Bank have gained at least 11% since mid-February. On the back of this rally, the beaten-down valuation of the sector has witnessed some improvement. In fact, those of some private sector banks have converged with their long-term averages. For example, HDFC Bank, Kotak Mahindra bank, Indusind bank and ICICI bank are now trading at a premium to their five-year average trailing price-to-book ratios.

As the cycle of non-performing loans (NPL) recedes, foreign brokerage see re-rating of the group to historical averages. A report recently noted that the top four private sector lenders in India are very profitable and well-capitalized barring the exception of Yes bank. Such features should help them gain market share. “ This in turn should drive the group to do well, after ~ 10% underperformance in the past 12 and 36 months,” concluded the brokerage house in a sector report.

According to Nomura — the most optimistic brokerage house on the market's potential to rise further this year — banks are likely to be a key beneficiary of the recalibration of market expectations regarding a favourable election outcome and benign inflation data. It also noted that asset impairment trends for key PSU banks like SBI and Punjab National Bank (PNB) have also slowed down.

Low valuations across the banking space for most part of the last year are partly justified due to muted expectations on economic growth. However, slowing loan growth and high provisioning have kept private sector banks particularly under pressure as they continue to record low asset quality quarter after quarter.Broadly, the street still maintains a cautious stance on PSBs.

As per Espirato Santo Securities, higher regulatory capital and higher provisioning requirements are the two major challenges confronting the PSBs over the next couple of years.